HH: It’s Friday, that means Larry Kudlow of CNBC’s Kudlow and Company joins me. Larry, what a week. You must have an Excedrin headache.

LK: Yeah, it’s been a long week. It’s a very interesting week. We got some good news today. The Fed is starting to come awake again, and they did cut their discount rate, that’s the lending rate to member banks, and they dropped it by fifty basis points. It’s a good first step, but they’ve got a lot more work to do, a lot more work to do. The credit crisis is still frozen, still in full bloom. Some parts of the money market like commercial paper, which are short-term loans to corporations, is completely dysfunctional. Everybody’s buying Treasury bills, which means we’re giving our money to the government instead of to American business, and that’s not a good thing. It’s risk aversion. So my feeling is we are looking at the importance of getting that Fed target rate down, probably a full percentage point…

HH: Wow.

LK: …in the next month or two. And the sooner the better, in my judgment. And that means that the Fed needs to push more new cash into the economy. So they’re lowering their base rate, but there’s more liquidity necessary to solve the freeze up in the credit markets. The stock market liked what the Fed did today a lot. Most of the gains occurred early in the morning when the announcement was made, and the market leveled off after that. Financial stocks have done much better on the encouraging news that the Fed is coming to its senses, but there’s still a lot more work to do. We could do this in eight to ten weeks if the Fed does the right thing.

HH: Now Larry, are you talking about the rate on overnight money? Or are you talking about cutting the prime?

LK: Right, well, the prime will follow down, but this is the basic…it’s called the Federal Funds Rate.

HH: This is what the mortgages key off of?

LK: Mortgages key off of this rate. This would be, you know, you want to stabilize housing values, you want to make mortgage payouts a little easier, the best way to do that is to cut the so-called Federal Funds Rate. The Discount Rate was done to stop bankruptcies of big lenders, big mortgage guys like Countrywide and others. Now those guys are suffering from a liquidity squeeze, because you still have a fear in trembling in these credit markets. There’s a certain cash hording. Nobody wants to take risks. They’re money good. Countrywide is money good. My friend Angelo Mozilo runs that thing. But the Fed said we’re not going to let them go down. We’re going to back them up. You know, that’s the traditional role of lender of last resort. That’s what they’re there for. But to really solve the mortgage credit problem, the corporate loan credit problem, the short term corporate commercial paper problem, to really solve that, and get people to move out of Treasury bills, and back into corporate financing, the way to do that, cut that target rate, and push more cash into the economy.

HH: Now you sound pretty confident, Larry Kudlow, that Bernanke’s going to actually do this. But when they met last week, it could have saved a lot of people a lot of equity if they’d just given a quarter point signal.

LK: Yes, indeed, and they bungled it. The bottom line is they bungled it. Look, what you saw today, they changed their policy leaning. Instead of inflation fighting, they are now coming around to economy worrying. So they’re finally accepting the fact that the credit crunch is not being contained, as they had maintained for so many months, that the sub-prime virus continues to spread. Not only in the U.S., by the way, but around the world as well. Now they acknowledged that today. That’s why this was such an important statement and action. It tells me with great certainty, Hugh, that they’re going to slash the Fed Funds Rate. But you know what? A quarter is not enough. You’ve got to look at that Treasury bill, which is down at 3 1/2%. That means the Federal Funds Rate should land at around 4 or 4 1/4%. Presently, it is 5 ¼%.

HH: Now Larry Kudlow, if they do that, won’t they be seen as politicizing the Fed in responding to George Bush’s need as the President? Or is this something you would expect them to do if a Democrat were in the White House as well?

LK: Yeah, anybody. This is not a political action. What they’re doing is acting on behalf of the nation’s banking system, and the nation’s economy. You cannot have a growing economy, with expanding jobs, if you freeze up and undergo a liquidity problem in the banking system. This is what central banks are for. This is what they’ve been put on this planet to do. Backstop the financial system during times of great stress or emergency. A lot of this, Hugh, is more fear than reality. But whatever, the attitude in the money markets and the credit markets is cash hording. And that means right now, they’ve got to add more money to meet these new cash demands.

HH: Now Larry Kudlow, yesterday, after the market opened, it went down about 200 points, I went in and bought equities. I bought some Google, I bought some Apple, I just thought this is crazy, this is panic. What are you advising people to do right now?

LK: Well, I would hang in there. I absolutely would hang in there. I mean, I believe in investing for the long term. I believe in investing in the long run future of the health of our free market, capitalist economy. And incidentally, incidentally, we got a bunch of numbers this week on retail sales and production that shows the economy’s still healthy. Growth is at least 2 1/2%, if not more. And we also got a number on Wednesday that inflation is being muted. So these are all positive events, and that’s why I would stay in the stock market, and not get caught up in these short terms wiggles and wobbles.

HH: Now I did meet with a California real estate baron yesterday, just passing the time of day, and he says it’s worse than it was in ’90-’91. Everything is dead, and they can’t figure it out, because the economy is good, but everyone says I’m just going to wait. How do you break that ice pack?

LK: Well, California’s one of the hardest hit states. In fact, there’s a handful of states where the real mortgage problems are. Cal’s one of them, Arizona is another, Florida is a third, Nevada is a fourth. And up in the Upper Midwest, the Detroit car Midwest, Indiana, Michigan and Ohio, all right? That’s a little different problem. The California thing’s going to take a while to work out. There’s no question about that, and there’s no quick fix there. There’s no quick fix there. The same is probably true in Arizona and Florida. You’ve got a lot of people, Hugh, speculating, investor speculating in condominiums and homes that frankly they never lived in.

HH: Right.

LK: And at the first sign of price drops, they ran away. So that’s going to take a while. But look, prices will fall. That makes the properties more affordable. The Fed gets these rates down, as they must, that makes the property more affordable, and will help stabilize the value, the prices.

HH: So let’s sum up, Larry Kudlow. Do you expect the Fed to move next week on the basic number they’ve got to get down and do a price cut?

LK: Interesting question. Their next meeting is September 18th. I do not believe they should wait that long. I think they should take actions to follow up on today’s discount cut. They should do it next week. That’s what I sincerely believe.

HH: Half point next week?

LK: I think that would be absolutely appropriate. I mean, the gap between their rate at 5 ¼% and the Treasury bill rate, at 3 ½%, is probably the widest it’s every been in my professional lifetime. And that’s a signal to the Fed, take action.

HH: Larry Kudlow, always a pleasure, Kudlow And Company, Monday through Friday, in uncertain times, a certain voice of reason.